Little breathing space for oil

John Kingston

Man and nature have conspired to produce an oil production perfect storm that has pushed crude prices to new highs and that isn't likely to reverse course any time soon.

IN THE TALKING HEADS SONG "ONCE IN A Lifetime," lead singer David Byrne wonders out loud: "Well . . . how did I get here?"

Àpropos of the worldwide oil industry, the answer is very simple. A few big boys (Venezuela, Iraq, and—in terms of growth rates—Russia) stopped producing as much as they did before. A pair of smaller guys (the demand twins, China and India) started buying more than they ever did before. Nature's fury hit the family jewels like it's never done before (in the form of the weather twins, Katrina and Rita).

Throw that all together, and it's hard to believe that the oil industry was actually laying people off—lots of them—as recently as 1999. The U.S. gasoline consumer, still probably the most important demand-side player in the market, was enjoying retail pump prices of less than $1 per gallon in many parts of the country as that year commenced.

From OPEC to Rita

Even the steady price rise that began in the first half of 1999, when OPEC discovered discipline it had heretofore abandoned, was wiped out in the wake of 9/11. Prices hit bottom about two months after that momentous day. Four years later, the market had tacked on $50 to the price of a barrel of crude.

And that's one of the cheapest rises. Gasoline, as measured by the Platts Gulf Coast pipeline price for conventional-grade gasoline, is up the equivalent of $52 per barrel since November 2001. Heating oil barges in the New York harbor assessed by Platts are up $56. And jet fuel, hit the most after the attacks on the World Trade Center, has surged by the equivalent of $61 per barrel in the Gulf Coast region.

Projecting anything of the future in the fall of 2005 is a difficult task in light of the impact of Katrina and Rita. By the end of the year, most of the refineries that were knocked out by the storms will either be operating or close to coming back on-line.

But there will still be significant wreckage left in the storms' wake. Nobody expects all of the lost production from the Gulf of Mexico or Louisiana state waters to come back on the market; not even all of the production outages from 2004's Hurricane Ivan had been restored when the new storms came ashore. Most refining capacity will be back, but not all of it. Strategic stocks drawn down by the International Energy Agency (IEA) after the storms will need to be replenished—exactly when isn't certain—giving a new boost to demand-driven pressures.

By mid-October, the 60 million barrels in stocks put on the market by the IEA had been mathematically offset by the cumulative amount of lost production. The question then shifted to whether demand destruction would be enough to counter the double jolt of lost upstream production and idled refining capacity.

But once the industry can declare that it has "gotten past" the storms of 2005 (and Ivan a year earlier) and then hope that there won't be a repeat performance in 2006, it still needs to deal with the question of whether the pre-storm price exceeding $60 is the norm or the aberration.

New baseline, old blame game

It took a long time, but Wall Street houses and other analysts gradually began raising their long-term forecasts in 2005 to reflect what is often grandly called the "new paradigm." And in these forecasts, prices of anywhere from $40 to $50 per barrel are increasingly seen as the new baseline. Those prices are not high; they are the new norm.

Why did it take many of those analysts so long to accept that—after years of declining real prices or, in some cases, actual prices—the market had moved to a new, higher plane? It might have been because of uncertainty over just how much of the move through the $50 and $60 marks was caused by that group of market participants that fly under the heading of hedge funds, noncommercials, or old-fashioned speculators. The price was inflated by $10, the price was inflated by $20 (name your number), but the reason was all the same. It was those speculators, and a lot of observers thought that they were to blame for many of the dollars in the higher price range.

But even before the twin storms hit, that accusation was heard far less. In early 2005, the New York Mercantile Exchange (NYMEX) did a study that found that the noncommercials did increase volatility, but not the outright price. Although the report was thorough, it could be dismissed as self-serving, even if that charge was unfair. Then, a few months later, the Commodity Futures Trading Commission (CFTC) said much the same thing, making it a little tougher to dismiss. The CFTC's report was far more detailed and read less like a defense of an existing business than a study put together by unbiased economists.

And when the International Monetary Fund (IMF) chimed in with its view on the issue, it too downplayed, without totally dismissing, the role of so-called "hot money." "The short-term behavior of prices together with higher volatility and increased trading activity in the futures markets suggest that speculative activity might be playing a greater role in driving spot and futures prices," the IMF said in a September report.

But after studying eight years of data, the IMF concluded that "speculative activity does not [IMF italics] precede movements in spot prices for either the short- or long-run components of the spot price. There is evidence, however, of a modest impact on the long-run component of long-dated futures prices. Irrespective of the component of the data considered, the causality tests imply that speculative activity follows movements in spot prices, thereby raising doubt about speculative activity being a key driver of spot prices. In particular, the results suggest that noncommercial net long positions increase after spot prices increase, suggesting that speculators generally assume that a rising trend in spot prices will continue."

Capacity crunch

The NYMEX and CFTC reports both observed that a noncommercial player could not risk taking delivery of a commodity. As a result, any length it took had to be rolled over into the next month or closed out completely, making the net ultimate impact on demand zero. And that always was the problem with the "it's all the speculators' fault" school of why the price was rising. The market bottomed out at less than $20 a little over two months following 9/11, and was at $65 when a bunch of rotating clouds that became Katrina were making their way over from the Azores. Did speculators do that?

No, a lack of spare capacity did that. In 1999, against world consumption of about 74 million bbl/day, the world probably had spare capacity of 5 million bbl/day, and those resources on the sidelines were more diverse than the heavy sour barrels that make up virtually all of current spare capacity. More recently, with global consumption probably set to average 83 million bbl/day for 2005, spare capacity at most is probably 2 million bbl/day, and it's mostly the kind of oil the world doesn't particularly want. That's a decline from about 6.7% to 2.3%, and it's tough to find a market for anything with that little spare capacity not becoming subject to inflationary pressures.

However, a strange thing occurred even as that spare capacity stayed tight. The market swung into "contango," where the forward prices going out several months ran higher than the current price. In a tight market, the opposite condition, backwardation, is the norm. Between October 2003 and November 2004, the backwardation on the NYMEX between the first and second trading months averaged 32 cents.

But for the next 11 months, through the end of September, with spare capacity probably tightening, the contango widened out to an average of 70 cents. That encourages stock building and is precisely what OPEC had in mind in March when it all but told its members to start pumping more crude into a market that at that point didn't need it. So inventories built, and the contango was the most visible sign of that.

Yet prices stayed lofty despite the enormous stock build, in part because the oil being put on the market was heavy and sulfur-laden, so nobody particularly wanted it. It was a market phenomenon few had ever foreseen: a contango during a time when everyone was shaking their heads and saying, "Do you believe these prices?" It was the result of simply too much crude on the market.

But prices climbed nonetheless. The surge had switched from being crude-driven over the first few years of this decade to one in which the price of products was the primary driver. The result for refiners in the U.S. and elsewhere was that they finally had a justification for all their refinery expenditures during the 1990s. During that decade, product prices barely budged, and low margins made petroleum refining and marketing one of the lowest-performing industrial sectors of the economy. The necessary investments to meet those standards caused much refining capacity to disappear, particularly in the U.S. Although de-bottlenecking at existing refineries led to jumps in individual capacity that amazed some company engineers, it wasn't enough to meet growing demand.

Build or buy?

Those trends presented refiners with a bounty they never could have envisioned 10 years earlier. The spread between Chicago gasoline and West Texas Intermediate (WTI) was $5 at the beginning of the year but had risen to $20 just before Katrina. And it wasn't just in the U.S.; the dated Brent to Rotterdam gasoil spread, as measured by Platts, averaged just under $11/bbl in January and $16.70/bbl in August, pre-Katrina. Even battered-down residual fuel, buffeted by the large amount of residual-heavy crudes on the market, bounced back from being valued in the Gulf Coast at around 22% of WTI in May to more than 30% in early October. (However, the recovery was boosted in part by the soaring value of competing natural gas.)

The change in the refining sector has been breathtaking. Benchmarks on operating performance outside the U.S. are not as transparent as those stateside, but the numbers for American plants are revealing. For example, when Valero began its buying binge in 1997 with the acquisition of Basis Petroleum (the former Phibro subsidiary), the San Antonio–based independent refiner paid all of about 10 to 15 cents on the replacement dollar. That figure needs to be placed in front of any pundit whining about the fact that there hasn't been a new refinery built in the U.S. for almost 30 years. If you can buy existing assets for such a pittance, why bother building new ones?

So building a new refinery now should be considered an easy decision to make. As Nike might say, just do it. But it's not that simple. For example, the one new refinery on the drawing boards, Arizona Clean Fuels near Phoenix, anticipates spending in excess of $16,000 per barrel of conversion capacity for its planned 150,000-bbl/day plant. By contrast, Valero's latest acquisition, of Premcor, went for about $10,000 per barrel of conversion capacity, a figure that Standard & Poor's (like Platts, the publisher of Insight, a division of The McGraw-Hill Companies) at the time called "unparalleled" and was more than triple the average refinery sales price since 2001.

In other words, existing assets still can be purchased for significantly less than their replacement cost. However, it should be noted that, although the market was groaning from having refineries on the shopping block a few years ago, owners of existing plants don't appear eager to sell under current, ebullient conditions. The rough estimate now is that sales of existing assets would go for more than the $16,000 level.

But as noted energy economist Philip Verleger wrote in a recent report, price-driven shifts may be under way that—with the benefit of 20/20 hindsight—will challenge the wisdom of building a new refinery. Millions of SUVs could be replaced by hybrids or by older or smaller cars. Ethanol use could surge beyond federal mandates. Exporters of crude, looking at the jaw-dropping crack spreads of today, could transition to selling products rather than crude and decide to construct massive new refineries. For example, Saudi Arabia has been studying bids this fall, some from Western oil companies, to build a new refinery at its port city of Yanbu.

These are factors that may need to be considered when the global oil industry asks that question again in a few years: "Well . . . how did I get here?"